SMSFs and property: What are the rules?

With the property market hitting all-time highs in 2021, interest in investing in direct property through your SMSF has never been higher.

In the September 2021 quarter, Australia’s SMSFs had almost $88 billion invested in non-residential real property, with another $47 billion in residential real property.

But before you join the trend and start adding property investments to your SMSF, there are some important rules you need to be aware of.

Rules for SMSF property investments

The key rule for all SMSF investments – not just property – is that they must meet the sole purpose test. This means your SMSF must be maintained for the sole purpose of providing retirement benefits to fund members or their dependants.

It’s also important to keep in mind the related party rule, which prohibits SMSFs from buying real property (including an existing residential investment property) from a related party. This means your relatives, business partners and their spouse or children, any company a fund member and their associates control or influence, or any trust a fund member or their associates control.

There are two exceptions. One is buying business real property like agricultural property, or a shop or office from which you operate your business. The other is if the value of the in-house asset is less than 5 per cent of your SMSF’s total assets.

Related parties and SMSF members can lease business and farming properties from your fund, but the arrangement must be at commercial market rates and paid in full on the due date. Renting residential or holiday properties to related parties – even if they pay market rent – is not permitted.

Borrowing the right way

Buying a property investment usually involves borrowing money. Again, strict rules apply.

SMSF loans are normally through a limited recourse borrowing arrangement (LRBA), although other structures such as tenants-in-common or related non-geared unit trusts may be acceptable. In the September 2021 quarter, SMSFs had almost $63 billion invested through LRBAs.

LRBAs prohibit lenders from seizing other assets in your SMSF if you default on your loan, so they tend to impose tougher loan conditions – if they offer one at all. Most lenders now require an SMSF to have a buffer of cash and/or shares equivalent to around 10 per cent of the property’s value. This is to ensure you have enough cash available to pay for expenses or a loss of tenant.

The rules also require you to establish a bare trust (which is separate from the SMSF) to hold the property asset. Restrictions are imposed on the modifications you can made to your property asset, with significant changes requiring a new loan. Improvements must be paid for from cash already in the SMSF, not borrowed money.

Be mindful of diversification

Although including property investments in your SMSF can be a great idea, they are expensive. Unless the fund has a high balance, they take up a large proportion of its total assets and reduce its diversification across asset classes.

Limited asset diversification leaves your SMSF exposed to investment risk and can also make it tricky to pay member benefits without needing to sell the property.

Adding an investment property must also fit within the fund’s investment strategy in terms of diversification, liquidity and maximising returns to fund members. The ATO no longer automatically accepts buying an investment property is in the best interest of members, if it is the main asset and the fund’s total balance is low.

The fund’s trust deed must also provide the trustees with authority to implement a borrowing arrangement.

Tax benefits

A key benefit of using your SMSF to invest in property is the concessionally taxed environment in super. Instead of paying your marginal rate, an SMSF only pays 15 per cent on any investment income the property earns. Once fund members retire, rental income is tax-free.

There are also capital gains tax benefits. Properties held by an SMSF for more than 12 months pay a discounted rate of 10 per cent on any capital gain when sold.

Interest payments on borrowings are tax deductible and if your SMSF’s expenses exceed its income, a taxable loss can be carried forward to offset future income. Losses cannot, however, be offset against your personal income.

That said, not following the tax rules can be costly. If a property investment doesn’t meet the requirements of the sole purpose test for example, a SMSF becomes ineligible for the normal super tax concessions.

And if you finance an LRBA through a related-party loan, the loan must meet the ATO’s safe harbour guidelines. Otherwise, the income and capital gain from the asset will be deemed non-arm’s length income and taxed at the top marginal tax rate.

There’s a lot to think about, so if you would like to discuss property investments and your SMSF give us a call.